What is an FX Collar?
An FX Collar is a combination structure that involves buying a protective, out of the money option and simultaneously selling another out of the money option on the same notional amount, but with opposite polarity.
The purpose of an FX Collar is to provide both a maximum and minimum exchange rate which the holder can pay, but to allow flexibility to benefit from the market rate in between.
How does it work?
A UK firm of exporters will be receiving USD 10,000,000 in a year’s time. They want to enter into a hedging contract to protect the conversion rate, so they buy a USD put/GBP call option. However, they do not want to pay a premium so they offset that by selling a USD call/GBP put option with a strike so that the premium is equal to that of the bought USD put option. The result is that the USD put option has limited the risk of USD depreciation, but the sold USD call option has limited the ability to benefit from USD appreciation.
- No upfront premium
- Offers protection above the strike of the bought USD put
- Allows benefit of lower market rate down to the strike price of the sold USD put
- Limits ability to benefit from USD appreciation
- Protected rate is above what could be achieved using a forward
- Termination could incur extra costs depending on the market rate at that time
FX Collar scenarios: